Dodd Frank Act Provisions
The Dodd Frank Act required the SEC to make a rule to adjust the net worth standards for Accredited Investors (under Regulation D promulgated under the Securities Act of 1933) applicable to natural persons individually or jointly with a spouse to “more than $1,000,000…excluding [emphasis added] the value of the primary residence of the natural person”. The quoted language is from the Dodd Frank Act and was effective July 21, 2010 when the Act was signed into law. Prior thereto, the value of the primary residence could be included in calculating net worth for purposes of the Accredited Investor determination.
SEC Rule Making
On January 25, 2011 the SEC issued a Release entitled Net Worth Standard for Accredited Investors setting forth its proposed rule implementing the changes made by the Act.
The Accredited Investor net worth standards in the SEC’s proposed rule would define as an Accredited Investor:
“Any natural person whose individual net worth, or joint net worth with that person’s spouse, at the time of purchase, exceeds $1,000,000, excluding the value of the primary residence of such natural person, calculated by subtracting from the estimated fair market value of the property the amount of debt secured by the property, up to the estimated fair market value of the property. “
The rule would require that the equity in the primary residence is the amount which is excluded from net worth - not the full fair market of the primary residence. Moreover, negative equity in the primary residence would not further reduce or further increase (absurd as a net worth increase from negative equity might have been) net worth.
The Skinny? The Essence of the Proposed Rule.
It may help to keep in mind that two calculations would be involved under the proposed rule. First, balance sheet net worth (assets – liabilities) is calculated. Second, a special calculation is made of Accredited Investor net worth (balance sheet net worth - any positive equity in the primary residence.)
The Fat? This Section Intended to be Read by Enthusiasts Only.
Consider the following examples from the Release:
1. If an investor with a balance sheet net worth of $2 million (calculated by subtracting from the investor’s total assets, including primary residence, the investor’s total liabilities, including indebtedness secured by the residence) has a primary residence with an estimated fair market value of $1.2 million and a mortgage loan of $800,000, the investor’s net worth for purposes of the new accredited investor standard would be $1.6 million.[1]
2. In 1 above, if the new standard did not allow exclusion of the associated indebtedness, removal of the primary residence would reduce the investor’s net worth by $1.2 million, for a revised net worth of $800,000, since the entire fair market value of the house ($1.2 million) would be subtracted from the investor’s net worth of $2 million and the $800,000 mortgage loan would still be included as a liability in the calculation.
3. if an investor with a net worth of $2 million has a primary residence with an estimated fair market value of $600,000 and secured indebtedness of $800,000, a $600,000 portion of the secured indebtedness would be netted against the entire $600,000 value of the house, so the investor’s net worth for purposes of the new accredited investor standard would remain at $2 million. The $200,000 in secured indebtedness in excess of the value of the property would already have been accounted for (i.e., subtracted from the value of other assets) in determining the investor’s balance sheet net worth. In short, for calculation of net worth for determining Accredited Investor status, indebtedness secured by the primary residence would be netted against the value of the primary residence only up to the fair market value of the property.
4. If an investor with a balance sheet net worth of $2 million has a primary residence with an estimated fair market value of $600,000 and a mortgage loan of $800,000 and no other secured indebtedness, the investor’s net worth for purposes of the new accredited investor standard is not $2,200,000 but rather stays at $2,000,000. Accredited Investor net worth is not effectively increased over the balance sheet net worth calculation by $200,000 (the amount by which the mortgage exceeds the value of the property). To add in negative equity to increase net worth would be Alice-in-Wonderland stuff indeed but nonetheless the Relaase does give this example.
No Definition of Primary Residence
The SEC proposed rule does not specifically define the term primary residence. The Release does state that issuers and investors should be able to use the commonly understood meaning of “primary residence” as the home where a person lives most of the time. In complicated cases, guidance can be found in such other contexts as in income tax rules or in rules determining what is a primary residence for obtaining a mortgage loan.
NASAA Go Home
The SEC rejected a recommendation by the North American Securities Administrators Association (“NASAA”) that the SEC not exclude from the calculation of Accredited Investor net worth related mortgage indebtedness where the mortgage proceeds are used to purchase securities. Put differently, in example 2 above, if the mortgage loan proceeds had been used to purchase securities, NASAA would have wanted the investor’s net worth to be only $800,000.
A perhaps more telling point by NASAA that net worth should require some minimal amount of assets in the form of securities was ignored in the SEC Release. Although the SEC would have no power to adopt such a rule in light of the Dodd-Frank Act language, a bolder SEC might have at least made an "expert" recommendation one way or the other to the Congress.
Issues for Comment and Comment Period
The SEC is seeking comment on whether some transition and other rules might be appropriate to facilitate subsequent investments by an investor who previously qualified as accredited but was disqualified by the change effected by the Dodd-Frank Act. For example, an investor who qualified as an Accredited Investor in a previous sale under Regulation D before enactment of the Dodd-Frank Act may wish to invest in the same company or fund in order to retain his or her proportionate interest in the company or fund or to exercise rights that have arisen because of that interest. Or a company may wish to make a rights offering to current investors who invested as Accredited Investors. In this case, the company may not wish to be subject to the additional information requirements it may incur under Regulation D if it offers and sells securities to non-accredited investors, and the company may be precluded from making the offering if the number of non-accredited investors exceeds the limit of 35 non-accredited investors imposed in Rule 505 and Rule 506 offerings. In some of these cases, the investor may have spent a substantial amount of time and money performing due diligence on the company or fund before his or her previous investments and may be familiar with the issuer as an existing investor. Under these circumstances, some have argued that the investor should be able to invest again as an accredited investor even if the investor does not satisfy the standards applicable at the time of the subsequent investment.
The SEC also has specified a number of other questions on which it is seeking comment.
The SEC has stated that all comments should be received on or before March 11, 2011.
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Robert Kiggins, Esq. of McCarthy Fingar LLP, is author of the blog, and may be reached at (914) 385-1024 or rkiggins@mccarthyfingar.com.
Nothing is this blog is intended to or may be relied upon as specific legal advice. Securities and related laws are complex and competent counsel should be consulted. Any opinions expressed herein are solely those of the author and not of any other person.
[1] Before Dodd-Frank, the primary residence would have contributed a net amount of $400,000 to the investor’s net worth for purposes of the accredited investor net worth standard—the value of the primary residence ($1.2 million) less the mortgage loan ($800,000). Under the proposed rule, exclusion of the value of the primary residence would reduce the investor’s net worth by the same amount of $400,000.
